What if the latest inflation figures are hinting at a major shift in the stock market? Tuesday’s report revealed a cooler inflation rate, sending ripples through the investment community and sparking speculation about small caps and lower-quality stocks potentially stealing the show.

The Bureau of Labor Statistics recently reported a year-over-year increase of just 2.7% in the consumer price index for July, which is slightly below the Dow Jones expected consensus of 2.8%. This unexpected dip has calmed fears of stagflation and ignited optimism that the Federal Reserve might cut interest rates more aggressively than previously thought.

Recent forecasts suggest the central bank could implement up to three quarter-point cuts this year—an upgrade from initial predictions of just two. As traders begin to grasp this new outlook, it could open the floodgates for small caps and lower-quality stocks, which have largely missed out on the gains enjoyed by larger companies so far this year.

Mike Wilson, Morgan Stanley’s chief U.S. equity strategist, noted that a lack of significant inflation pressure indicated by the July CPI could increase the bond market’s pricing for a September rate cut, which now stands at an impressive 90% probability. “This scenario has the potential to catalyze a more durable rotation to small caps and lower-quality stocks,” Wilson shared just a day before the CPI report dropped.

With the S&P 500 boasting over an 8% increase year to date, investors have flocked to larger companies with robust balance sheets, seeking refuge amid the uncertainty from Washington and a tumultuous macroeconomic landscape. However, a more favorable monetary policy outlook could be a game-changer for smaller companies and those with weaker financial positions, as they are particularly sensitive to shifts in interest rates.

Looking ahead over the next six to twelve months, Wilson expressed a bullish outlook fueled by a recovering earnings environment and improved cash flow. Should these asset classes begin to catch up, there’s a significant gap to close; the small-cap Russell 2000 has barely scraped together a gain in 2025, while even the equal-weighted broad market index has only risen about 4%. Some stocks that fall into the lower-quality category include Caesars Entertainment, United Airlines, and Dollar General, highlighted in a recent Goldman Sachs analysis.

“We believe that equity investors should remain agile as this week's CPI report could signal an impending leadership shift in the market,” Wilson concluded, hinting that the landscape may be on the brink of a fascinating transformation.